Risk/Reward ratio: the truth beyond the myth

Every trading coach teaches something about the Risk/Reward ratio. It seems a necessary task in every trading course, as it was the most important thing in a trading strategy. In reality, RR is not the most important thing, but we cannot forget to take a look at it. So let’s go into the deep of this parameter.

Important: in the following article I’ll call RR the ratio between reward and risk (reward / risk). So RR=2 means “a reward 2 times grater than the risk”.

I’ve said that RR is not that important. So what really is? The answer is: expected payoff.

Given RR the Reward/Risk ratio and p the success rate of our trading strategy (i.e. the fraction of profitable trades in a sequence), for any given Risk the expected payoff for a single transaction in the long term is:

There is no magic behind this formula. It’s simple statistics. If you are curious, you can easily read the Wikipedia article on the Expected Value.

Expected payoff is the key of trading. Someone calls it “statistical edge”. In simple words, if expected payoff is positive, our strategy makes profits in the long term, otherwise it’s not profitable and will make us lose money.

So, the key is: keep expected payoff positive. The higher, the better.

Now, this is only statistical stuff. Let’s go back to reality and apply it in the real world.